Laws Corporation is considering the purchase of a machine costing $16,000. Estimated cash savings from using the new machine are $4,120 per year. The machine will have no salvage value at the end of its useful life of six years and the required rate of return for Laws Corporation is 12%. The machine's internal rate of return is closest to (Ignore income taxes.):Click here to view Exhibit 14B-1 and Exhibit 14B-2, to determine the appropriate discount factor(s) using the tables provided.

Question

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To find the internal rate of return, we need to find the discount rate that makes the present value of the cash savings equal to the initial cost of the machine. Using the present value of an annuity table in Exhibit 14B-1, we find that the discount factor for six years at a 12% required rate of return is 4.111. Therefore, the present value of the cash savings over six years is $16,912 (4.111 x $4,120). This is greater than the initial cost of the machine, so we need to try a higher discount rate. Using trial and error or a financial calculator, we find that a discount rate of approximately 14% makes the present value of the cash savings equal to the initial cost of the machine. Therefore, the internal rate of return is approximately 14%.

Laws Corporation Is Considering the Purchase of a Machine Costing